In this edition of our Bookkeeping Basics series, we’ll cover the basics of business operating costs, including what counts and how to manage operating costs in the Profit First accounting method we advocate here at Moxie. (Find out more about Profit First.)
What is overhead?
Your overhead is any expense that’s vital to running your business. For example, say you buy 10 duck boats and go into business as a tour guide operator. Your overhead would include items like your website, the office near the water where you sell tickets and tours, your utilities and your marketing.
If you want to get technical, your operating costs will include your SG&A: selling, general and administrative costs.
What is the difference between a business operating cost and a business operating expense?
Operating costs and operating expenses are two terms for the exact same thing, so you can use either term. You might also see the terms operating expenditures or opex. But you can always just call it what it is: overhead.
Why is overhead important?
It’s important to understand your business’ operating costs because they’re one of the keys to understanding whether your business is actually profitable. Knowing that overall number “highlights the cost and needs that a company needs to make to generate revenue, which is the main goal of a company.”
You can look at your overhead as a percentage of revenue (and compare it to your competitors’ numbers) to get a feel for how the two compare (though what percentage it “should” be can vary). Keeping your operating costs as low as possible will help your business be sustainable and profitable and keep more cash flow open.
What counts as overhead?
Any expense that’s directly related to the day-to-day running of your business is an operating cost. Think:
- Rent on that little building near the dock where you sell duck boat tickets
- Interest payments (on that boat you bought with a loan)
- Utilities and property taxes
- Depreciation, repairs and maintenance on your boats
- Salaries
- Legal fees (if your boat sinks)
- Travel costs (for eyeballing the latest boat up for sale in Argentina)
- Non-depreciable office supplies (e.g., pens, copier paper)
- Lawsuit settlement expenses (from that boat that sank)
“Operating (and non-operating) expenses can be fixed—unaffected by changes in production volume or service delivery—or variable, meaning they fluctuate in proportion to the changes in volume or delivery. Rent and salaries are examples of fixed operating expenses, while fuel and sales commissions are examples of variable operating expenses.” – Oracle Netsuite
What doesn’t count as overhead?
What counts as an operating expense for your business will vary widely by industry, so you’ll likely want to consult an expert about your specific situation. Here are examples of the expenses that generally don’t count as operating costs:
- Capital expenditures (your duck boats, maintenance equipment)
- Costs from currency exchanged (on that boat you bought in Argentina)
- Write-down of receivables or inventory
Why doesn’t my cost of goods sold count as overhead?
This is a controversial question in the accounting realm. (Ah, well do I remember the COGS throwdown of 1974. Spectacles and ledger pages flying everywhere. Tragic.)
Your cost of goods sold, or COGS, will include your inventory, the cost of shipping new inventory to you, any manufacturing costs and the packaging you use. This is important because your markup on your Direct Costs has to be enough to cover your overhead. Poor markup on COGS is one of the main reasons businesses don’t have profit.
In our duck boat example, if you sell products with your logo to tourists, your COGS might include:
- The hats and koozies you keep in stock
- The cost of having them customized
- The cost of having them shipped to you
- Tissue paper and gift bags
While COGS are a kind of expense, they’re not overhead.
In the Profit First accounting method, we call COGS “Materials and Subcontractors,” and if they are significant (25% or more of your income), then we set that money aside before making any other allocations.
Do marketing and sales costs count as overhead?
Marketing and sales costs are overhead, while sales themselves count as income.
Next year’s accounting starts now.
We regularly help our clients set up sustainable business habits with Profit First accounting. Schedule a complimentary call with me, where we’ll talk more about putting profit first.